NATIONAL BUREAU OF ECONOMIC RESEARCH THE

of the world experiences higher GDP and consumption in the long run.Comparing business cycle fluctuations around the pre- and post-deregulation steady states, wealso show that less monopoly power in financial intermediation results in less volatile businesscreation, reduced markup countercyclicality, and weaker substitution effects in labor supply inresponse to productivity shocks–the source of business cycles in our model. Removal of bankingsegmentation thus contributes to moderation of firm-level and aggregate output volatility.7 In turn,trade and financial ties between the two countries allow also the foreign economy to enjoy lowerGDP volatility in most scenarios we consider.8Interpreting the economy that removes banking segmentation in our exercise as the U.S., thepredictions of our model are consistent with features of the U.S. and international business cyclefollowing the waves of U.S. banking integration started at the end of the 1970s: The U.S. experiencedreal appreciation and significant external borrowing in the first half of the 1980s and after the mid1990s–periods that followed the first wave of deregulation and the completion of the transitionto interstate banking, respectively. The decades after the early 1980s–and before the crisis thatbegun in 2007–were also marked by a reduction of macroeconomic volatility around the world.9Our paper thus offers an explanation of developments in the U.S. and international business cyclethat complements those already present in the literature.10The conventional explanation for the contemporaneous occurrence of U.S. exchange rate appreciation and external borrowing in the 1980s relies on the traditional Mundell-Fleming analysis ofthe consequences of expansion in government spending and the monetary policy contraction implemented by Paul Volcker’s Federal Reserve. But the tight association between federal budget andexternal balance has been challenged by recent literature. For instance, Erceg, Guerrieri, and Gust(2005) find that a fiscal deficit has a relatively small effect on the U.S. trade balance, irrespective7The reduction in firm-level volatility is consistent with evidence in Correa and Suarez (2007), who find a causallink between banking deregulation and lower firm-level volatility in the U.S.8Our model also implies that the removal of banking segmentation in one of the two countries improves long-runwelfare in both countries as households enjoy higher utility from consumption that more than offsets the disutility ofhigher labor effort.9Stock and Watson (2003) document that the decline in U.S. business cycle volatility begun in 1984. Our modelpredicts that it takes approximately six years for the number of producers to reach the new steady state followingbanking deregulation. Thus, the prediction of the model is consistent with a reduction in business cycle volatilityobserved approximately six years after the first wave of deregulation in the late 1970s.10Since our model predicts permanent real appreciation following permanent banking deregulation, the model doesnot explain the return of the U.S. effective real exchange rate to pre-appreciation levels after the appreciation phasesin the 1980s and 1990s. This can be attributed to the reversal of other forces that contributed to the appreciationsas well as, for instance, coordinated exchange rate intervention in the second half of the 1980s. If one views bankingintegration as a characteristic of more developed countries, the prediction of persistently higher average prices isconsistent with the evidence that prices are indeed higher in higher-income countries.3

of whether the source is a spending increase or a tax cut. With respect to U.S. trade balance andreal exchange rate dynamics in the second half of the 1990s, Hunt and Rebucci (2005) concludethat accelerating productivity growth in the U.S. contributed only partly to appreciation and tradebalance deterioration. They find that a portfolio preference shift in favor of U.S. assets and uncertainty and learning about the persistence of both productivity and preference shocks are neededfor their model to explain the data. Rather than emphasizing the demand-side effect of preferenceshifts, Caballero, Farhi, and Gourinchas (2008) provide a model that rationalizes external imbalances as the outcome of growth differentials across different regions of the world and heterogeneityin these regions’ capacity to generate financial assets. Mendoza, Quadrini, and Ríos-Rull (2009)argue that imbalances can be the outcome of international financial integration when countriesdiffer in financial market development (interpreted as the enforcement of financial contracts) andshow that countries with more advanced financial markets accumulate foreign liabilities in a gradual, long-lasting process. Finally, Fogli and Perri (2006) argue that imbalances are a consequenceof business cycle moderation in the U.S. In their model, if a country experiences a fall in volatility greater than that of its partners, its relative incentives to accumulate precautionary savingsweaken, and this results in an equilibrium deterioration of its external balance.11 The moderationof business cycle volatility between the 1980s and the crisis that begun in 2007–often referred toas the Great Moderation–has been the subject of extensive literature that attributes it partly tofavorable changes in the shocks to the economy and partly to improved policy.12Our model provides a complementary explanation of observed phenomena, based on the effectsof removal of banking segmentation that made the U.S. banking system more competitive (at thelevel of local borrowers) than that of the rest of the world.13 We emphasize that our results hingeon lower bank monopoly power at the local level. Even if bank consolidation was a well documentedphenomenon in the U.S. since the 1980s, it is well established by the empirical finance literaturereferenced above that interstate banking reduced the degree of bank monopoly power at the levelof local borrowers–put differently, while the total number of U.S. banks may have declined as a11Other explanations of the recent dynamics of the U.S. external position emphasize demographics (Ferrero, 2007),a “global saving glut” (Bernanke, 2005), and valuation effects (Gourinchas and Rey, 2007).12See Stock and Watson (2003) and references therein. An incomplete list of more recent, relevant referencesincludes Cogley and Sargent (2005), Giannone, Lenza, and Reichlin (2008), Justiniano and Primiceri (2008), andSims and Zha (2006).13Our analysis can of course be applied also to the intra-European and international consequences of bank marketintegration within the European Union (EU) since the signing of the Single European Act in 1986. However, theprocess of EU banking integration has been lagging behind the implementation of interstate banking in the U.S. Seethe Appendix for historical details. De Bandt and Davis (2000) provide evidence that the behavior of large banks inEurope was not as competitive as that of U.S. counterparts over the period 1992-1996. Regarding small banks, thelevel of competition in Europe was even lower.4

result of consolidation, the number of those represented at any given location tended to increase,generating the effects that we capture. In our model, a differential in the competitiveness of thebanking system induces real appreciation of the dollar and U.S. external borrowing by making theU.S. a more attractive environment for business creation. As in Caballero, Farhi, and Gourinchas(2008), Mendoza, Quadrini, and Ríos-Rull (2009), and Fogli and Perri (2006), current accountdeficit and the accumulation of a persistent (although not permanent) net foreign debt positionarise as an equilibrium phenomenon. However, while Caballero, Fahri, and Gourinchas do notlink business cycle moderation with global imbalances, and Fogli and Perri take moderation asexogenous, we provide a unified explanation of external borrowing during the post-deregulationtransition and eventual business cycle moderation for given stochastic productivity process withoutrequiring long-run productivity differentials.14 An element of similarity between our approach andthose of Caballero, Fahri, and Gourinchas and Mendoza, Quadrini, and Ríos-Rull is that net foreignasset imbalances arise as a consequence of capital mobility across asymmetric financial systems:In Caballero, Fahri, and Gourinchas, there is asymmetric ability to generate financial assets; inMendoza, Quadrini, and Ríos-Rull, there is asymmetric enforcement of financial contracts; in ourmodel, the removal of within-country bank market segmentation results in an asymmetric degreeof banking competition across countries.15The remainder of the paper is organized as follows. Section 2 presents the benchmark modelwith non-traded goods under a balanced trade assumption. Section 3 discusses real exchange ratedetermination in our model and the mechanism for appreciation following banking deregulation.Section 4 presents impulse responses to a permanent, unilateral banking deregulation that substantiate the results and intuitions in Section 3. Section 5 extends the model to allow for internationalcapital flows to show the emergence of external borrowing in response to deregulation. Section 6incorporates countercyclical firm markups and elastic labor supply to highlight the mechanism for14Of course, our model does not explain (and does not aim to explain) the period of financial market turmoil thatbegun in 2007 and its business cycle implications. For this purpose, the model should include–at a minimum–heterogeneity in borrower quality, asymmetric information, and equilibrium default in response to the state of theeconomy. One could then re-cast the analysis of entry subject to sunk costs as one of the decision by heterogeneoushouseholds to enter home ownership, facilitated by various forms of market deregulation that made access to financeeasier. But this analysis is beyond the scope of this paper.15By focusing on the role of financial intermediaries, our paper also contributes to a recent, fast growing literatureon the consequences of endogenous producer entry in macroeconomic models. In addition to the works mentionedabove, see Bergin and Corsetti (2008), Bilbiie, Ghironi, and Melitz (2008), Corsetti, Martin, and Pesenti (2007,2008), Elkhoury and Mancini Griffoli (2006), Ghironi and Melitz (2007), Méjean (2008), and Lewis (2006). Our setuppreserves the key international relative price and external balance implications of entry in the Ghironi-Melitz modelwhile removing firm heterogeneity and fixed export costs as a source of endogenous non-tradedness and introducingan exogenous non-traded sector (as in Méjean, 2008) or home bias in preferences.5

the moderation of business cycle volatility. Section 7 concludes. The Appendix contains a summaryof the U.S. transition to interstate banking between the late 1970s and the mid 1990s, technicaldetails, and the model with home bias.2The Benchmark ModelWe begin by developing a version of our model under financial autarky.The world consists of two countries, home and foreign. We denote foreign variables with anasterisk. Each country is populated by a unit mass of atomistic, identical households, a discretenumber of banks, and a continuum of firms. In each country, there are several exogenously givenlocations with a discrete number of banks and a local continuum of firms in each of them. Monopolistically competitive firms in the traded sector must borrow from banks to finance sunk entry costs,and they have no collateral to pledge except a stream of future profits.16 Each firm then producesa firm-specific consumption good for sale in the domestic and export markets. Firm entry reducesthe stream of future profits of both incumbents and entrants–and thus the amount pledgeable forentry loan repayments–by reducing the share of aggregate demand allocated to each firm.Before deregulation, firms are restricted to borrow from local banks. These use their monopolypower on the loans they issue to extract all the future profits from the prospective entrants theyfinance. Each bank holds a portfolio of outstanding loans and decides on the number of new loansto be issued (that is, on the number of entrants to be financed) in each period.17 Each bank tradesthe increase in revenue from expanding its firm portfolio (portfolio expansion effect) against thedecrease in revenue from all firms in its portfolio due to reduced market share per firm (profitdestruction effect). The profit destruction effect induces credit rationing at the extensive margin:Less prospective entrants receive funding than with perfectly competitive financial markets. Eachbank supplies one-period deposits to domestic households in a perfectly competitive deposit market.The bank then uses the deposits to fund firm entry. Thus, the cost that each bank faces is thedeposit interest rate. Bank deregulation lifts the restriction on borrowing from banks at a differentlocation within the country. The number of banks to which a borrower has access increases, hencereducing bank monopoly power.1816Financial frictions that we leave unspecified force prospective entrants to borrow the amount necessary to coversunk entry costs from banks rather than to raise funds directly in equity markets.17Banks compete in the number of entrants in Cournot fashion as in the static, partial equilibrium model ofGonzález-Maestre and Granero (2003). Since banks extract all firm profits through loan repayments, banks de factohold portfolios of firms in the economy. Financial intermediaries are equity holders also in Gertler and Karadi (2009).18Since the completion of financial deregulation in the U.S. in 1994, it is increasingly less plausible to view bank-6

For expositional simplicity, we present the model economy below normalizing the number ofbanking locations in each country to one. We denote the number of banks represented at thislocation with H 1 (H in the foreign country). If the number of locations were M 1, following integration of the home banking market, the product HM would replace H in the equationswhere this appears: Before deregulation, prospective entrants can borrow only from the H banksrepresented at their location; after deregulation, they can borrow from HM banks. Having normalized the number of locations to one, this is isomorphic to an increase in the number H of banksrepresented at this location.19,20All contracts and prices in the world economy are written in nominal terms. Prices are flexible.Thus, we only solve for the real variables in the model. However, as the composition of consumptionbaskets in the two countries changes over time (affecting the definitions of the consumption-basedprice indexes), we introduce money as a convenient unit of account for contracts. Money plays noother role in the economy. For this reason, we do not model the demand for cash currency, and weresort to a cashless economy as in Woodford (2003).HouseholdsWe focus on the home economy. The representative home household supplies L units of labor inelastically in each period at the nominal wage rate Wt , denominated in units of home currency. The1 γPs t (Cs )household maximizes expected intertemporal utility from consumption (Ct ), Et s t β1 γ ,where β (0, 1) is the subjective discount factor and γ 0 is the inverse of the intertemporal elas-ticity of substitution, subject to the budget constraint specified below. At time t, the householdconsumes the basket of goods Ct (CT,t /α)α [CN,t /(1 α)]1 α , where CT,t is a basket of home andforeign tradable goods, CN,t is a non-tradable good, and α (0, 1) is the weight of the tradablebasket in consumption.21 The consumption-based price index is then Pt (PT,t )α (PN,t )1 α , whereing markets as local (Cetorelli and Strahan, 2006). The ability of banks to expand across local markets and newtechnologies that allow banks to lend to distant borrowers act to limit the incumbent banks’ local monopoly power(Petersen and Rajan, 2002).19We remark that while the normalization M 1 implies that H becomes the total number of home banks in themodel presentation below, our results do not hinge on deregulation resulting in an increase in the total number ofhome banks in reality (or in the model without normalization). In fact, consolidation post-deregulation lowered thetotal number of banks in the U.S. But this is not inconsistent with an increase in the number of banks represented ineach location, and a decline in their local monopoly power (consistent with the evidence), which is what our modelis intended to capture.20We abstract from endogenous entry into banking as function of economic conditions (for given regulatory environment). While there is evidence of cyclical variation of entry in goods markets (see Bilbiie, Ghironi, and Melitz,2007, and references therein), the evidence of bank creation at business cycle frequency is less pervasive.21Differently from Ghironi and Melitz (2005), we do not model the endogenous determination of the subset oftraded goods within a tradable set, since this is not central to the analysis in this paper. All tradable goods that7

PT,t is the price index of the tradable basket, and PN,t is the price of the non-tradable good. The¡R θ/(θ 1), where θ 1 is the symmetric elasbasket of tradable goods is CT,t ω Ω ct (ω)(θ 1)/θ dωticity of substitution. At any given time t, only a subset of goods Ωt Ω is actually available forconsumption at home and abroad. Let pt (ω) denote the home currency price of traded good ω Ωt .³R 1/(1 θ). The household’s demand for each individual traded goodThen, PT,t ω Ωt pt (ω)1 θ dωω is ct (ω) α (pt (ω) /PT,t ) θ (Pt /PT,t ) Ct . The household’s demand for the non-tradable good isCN,t (1 α) (Pt /PN,t ) Ct .The foreign household supplies L units of labor inelastically in each period in the foreign labormarket at the nominal wage rate Wt , denominated in units of foreign currency. It maximizes asimilar utility function, with identical parameters and similarly defined consumption basket. Thesubset of tradable goods available for consumption in the foreign economy during period t is Ω t Ωand it coincides with the subset of tradable goods that are available in the home economy (Ω t Ωt ).Households in each country hold two types of assets: one-period deposits supplied by domesticbanks and shares in a mutual fund of domestic banks.22,23 We assume that deposits pay risk-free,consumption-based real returns.24 Let xt be the share in the mutual fund of H home banks held bythe representative home household entering period t. The mutual fund pays a total profit in eachPperiod (in units of currency) equal to the total profit of all home banks, Pt h H π t (h), where π t (h)denotes the profit of home bank h. During period t, the household buys xt 1 shares in the mutualfund. The date t price (in units of currency) of a claim to the future profit stream of the mutualPfund is equal to the nominal price of claims to future profits of home banks, Pt h H vt (h), wherevt (h) is the price of claims to future profits of bank h. In addition to mutual fund share holdings xt ,the household enters period t with deposits Bt in units of consumption. It receives gross interestincome on deposits, dividend income on mutual fund share holdings, the value of selling its initialshare position, and labor income. The household allocates these resources between consumptionand purchases of deposits and shares to be carried into next period. The period budget constraintare produced in equilibrium are also traded, and there is an exogenously non-tradable good in each country. Wepresent in the Appendix an alternative version of the model in which there is no non-tradable good, and home biasin consumption preferences for tradable goods is the source of PPP deviations.22Because of the assumption that banks de facto own domestic firms, this implies that households are the ultimateowners of the firms. However, as

purchasing power parity (PPP), and monopoly power in financial intermediation. Our model builds on Ghironi and Melitz (2005) and Bilbiie, Ghironi, and Melitz (2007) by assuming that investment in the economy takes the form of the creation of new